Defining a Real Estate Bubble

A few years’ ago you could scarcely open a financial newspaper or magazine without running into talk of the housing bubble that was destined to burst. Since then, the bubble has definitely exploded, laying waste to millions of investors and homeowners alike, and now lies like a limp balloon at the bottom of the market, waiting for another round of wild speculation to inflate it again. If there’s one thing we know with almost absolute certainty, it’s that there will be another real estate bubble at some point in the future. And another. And another…

What goes into a housing bubble? It might help some people to think of a housing bubble much like any other kind of bubble. While most are filled with air, a housing bubble is full of speculation, which might bear a surface resemblance to investing, but really isn’t like it at all.

Let’s take a look at to put some space between these two ideas.

Investment: “The investing of money or capital in order to gain profitable returns, such as interest, income, or appreciation in value.

Speculation: “Engagement in business transactions involving considerable risk but offering the chance of large gains, especially in trading commodities, stocks, etc., in the hope of profit from changes in the market price.”

Alrighty then, let’s look at some of the differences in these terms.

  • Investing vs. Considerable Risk
  • Profitable Returns vs. Large Gains
  • Value Appreciation vs. Changes in Market Price

When a house is purchased as an investment, the owner is more concerned with it naturally increasing in value, normally over a longer period of time – years or maybe even decades. A rental property that brings in enough monthly income to cover the mortgage and deliver a reasonable rate of return is considered a good investment. In contrast, speculation is a more mercenary undertaking. Speculators are rarely concerned with the inherent value of the asset they own, and they likely won’t own it long. Their primary purpose is to jump in as the price shoots upward and then sell it quickly to someone who’s willing to pay a higher price.

Bubbles like the housing market of the mid 2000s are characterized by a rapid increase in price, an increase driven by the fact that speculation is, at heart, an impulsive pursuit driven by “investors” who don’t want to miss out on the chance to make a lot of money quickly. The development of a bubble requires an impulsive buyer and a shallow market. As opposed to deep markets, which can absorb temporary supply shocks, a shallow market (like local real estate) tends to react wildly to shortages or gluts in supply. Prices can shoot up quickly and then drop just as fast.

Ultimately, bubbles are driven by speculation and speculation is all about human psychology. Deep-pocketed speculators can sense a developing bubble like sharks sense blood in the water. They swoop in and buy everything in sight. Those on the outside, with fewer resources, see an “opportunity” to make a bunch of money. They throw their good sense out the window and pay too much for an asset. Often they buy at the top of a price range, expecting prices will continue to climb. The problem is, by this time, the big speculators behind the buying surge that kicked the whole thing off have seen their money increase exponentially. They bail out with a healthy profit. With the demand that was driving the whole thing now gone, latecomers to the buying party are left to watch the value of their assets decline, sometimes sharply and quickly.

Though it’s often hard to see a bubble until after it pops, one factor to keep an eye on is a detachment of price from fundamentals. In real estate, watch rental rates versus the selling price of the house. When prices swoop up considerably but rentals remain essentially the same, there’s a good chance you’re looking at a bubble.

The Role of Unsecured Lending
During the first few years of this century, lenders (with prodding by the Federal government) fell into the habit of offering unsecured loans, defined as a loan that has no claim on the borrower’s personal assets, only the underlying value of the asset. When it comes to housing, these are often characterized by no or low down payment loans. Sound familiar? It describes the foreclosure mess and subsequent housing market crash precisely.

And what do we have now that the bubble has burst? Required mortgage down payments that usually reach 20 to 25 percent of the purchase price.

Bubble burst (Top image: Flickr | zzub nik).

The American Monetary Association Team

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